Monday, 23 February 2009

Three posts in 24 hours, Mr Peston? Back from your holiday and full of energy it seems.

One of the enduring phenomena in macroeconomics is stickiness. This most commonly shows up in the idea of 'sticky prices', which in some models are responsible for business cycles. In short, prices of goods and wages increase beyond the level of stable demand (perhaps driven by higher short-term demand or by inaccurate expectations of rising demand). The demand curve turns out to be a bit lower than was thought, but prices do not immediately adjust downwards in response. Therefore the amount of goods supplied is less than the optimal (equilibrium) amount and we get a recession.

There are many other examples of stickiness, or as I referred to it in an earlier post, friction. But one that I have not seen discussed is policy stickiness. Robert Peston highlights this in an item today about Northern Rock.

The British government is changing its original policy of running down Northern Rock's loan book to minimise losses to the taxpayer on risky loans. While this policy was probably the correct one in an economy which was still growing and credit-driven, it is unlikely to be right in a recession with a shortage of credit available.

Now the government intends to change Northern Rock's policy and start extending new loans. One key feature of these loans will be a higher loan-to-value (LTV) ratio than is typically available in the private sector - 80-90% instead of the usual 75%. This seems like a good idea, though it does remind me of the effect last year where Northern Rock - because it had the only full government guarantee of all deposits - soaked up an artificially large proportion of the savings market for a time. I don't think this would be a major problem in the current environment, but it is something to watch in the future.

But it has been reasonably clear for several months at least that this was the case. The government has been trying to encourage lending and it has a captive lender representing a large share of the mortgage market. I believe we have a rational government and that the Treasury provides good advice to its ministers.

So why hasn't policy changed earlier? There is clearly a stickiness. Part of this arises from criticism of "U-turns" - if the government changes its mind quickly, it is often pilloried for lack of resolve. Part arises from a desire to let a policy play out to see if it is going to be effective. Part comes from a game-theoretic calculation (whether conscious or not) in which government does not wish to be seen as easy to influence and thus create an incentive for private parties to try to change its mind instead of following its dictates.

So there is a stickiness in the private sector and a different stickiness in the public sector. We hope that the non-sticky parts of each sector will help to cancel each other out - emergency fiscal stimulus is a good example. A non-sticky, quickly adjusting economy is the holy grail of macroeconomic stability and is a goal worth spending lots of time on.

A completely rational actor in either sector will behave in a less sticky way than do real people. It will be interesting to analyse specific departures from rationality and see whether they imply that stickiness is correlated. If so, it will show us where we need to work to improve the flexibility of the economic system.

One of the successes of interest rate management in recent years has been the ability to flex without creating the appearance of a policy U-turn.

Economies need 'escape valves' so that the total amount of demand and supply - as well as the amount in individual sectors and regions - can adjust as appropriate. When the private sector is not flexible enough, and the central bank and credit system are at the limits of their flexibility, the public sector has to provide flexibility instead. Thus an ability to run less sticky policy could substantially reduce the impact of recessions and make a difference of tens of billions - or hundreds of billions in the case of the US economy.

In my list of cognitive biases, anchoring is the most obvious candidate to explore this issue; loss aversion and limited cognitive power have an impact too. Another item for the research list.

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About this blog

This blog is about cognitive and behavioural economics. It discusses their impact on economic theory, and how to apply them in business, especially in pricing and marketing. It also explores how our perceptions and mental models affect the macroeconomy.

My other blog is Pricing Revolution, specifically around innovative pricing models and advice on how businesses can set their prices.

Other things I do

As well as writing this blog, I am chief executive of Inon Pricing Advisers - which uses behavioural economics and psychology research to help companies charge the right prices for their products. Please click through to find out more.

I am also founder of think tank Intellectual Business which publishes research and policy papers on how ideas from economics can be used in business and in the public sector.